Diversity Matters in the World of Finance: Does Ethnic and Religious Diversity Hinder Financial Development in Developing Countries?

Abstract

This paper investigates the relationship between ethnic and religious diversity (ED and RD) and financial development using the data from 102 developing countries. It is widely accepted that financial depth and the more ready availability of finance have a central role to play in fostering economic growth. We hypothesize that financial development in developing countries, especially those at the early stages of economic development, may be retarded by preexisting ED and RD, which may produce conflict. However, we believe that this risk can be moderated by sound institutional functioning, including good governance and democracy. Financial development is measured using M2 and private credit, both as a percentage of GDP, while ED and RD is measured using the Alesina fragmentation index. Our results are supportive of our hypothesis that ED and RD can indeed hamper financial development; these risks, however, are mitigated by well‐functioning institutional arrangements.

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